Stocks are down sharply since reaching record highs in 2007. You may now hold stocks and stock funds that are trading at less than the price for which you bought them.
Strategy: Harvest capital losses in your taxable investment accounts. You’ll lock in immediate tax savings and position yourself for greater long-term after-tax returns.
Ground rules: Net capital losses of up to $3,000 may be deducted against ordinary income each year. Losses that can’t be deducted may be carried forward indefinitely to offset gains in future years.
HOW MOST PEOPLE DO IT
Most people think of tax-loss harvesting as something you do at the end of the year.
Example: Tom Williams tallies his 2008 trades for the year-to-date in early December. He realizes that he has net long-term gains of $10,000 for the year.
If he takes no further action, Williams will owe $1,500 on these transactions, at a 15% rate for long-term capital gains (as high as 35% for short-term gains), when he files his tax return next year.
Instead, Williams sells enough shares of a bank stock to realize a $13,000 capital loss. He immediately reinvests the proceeds in another bank stock, which he expects to perform about the same as the stock he sold. It is important that he does not repurchase the same stock — otherwise, the wash-sale rule would be triggered and disallow the recognition of the $13,000 capital loss.
Result: Williams’s $10,000 net realized gain has been converted to a $3,000 net capital loss for calendar year 2008, with no major change to his overall investment posture.
Instead of owing $1,500 to the IRS, he’ll have a $3,000 tax deduction (against his ordinary income), worth $1,050 in the top 35% federal income tax bracket.
Therefore, Williams will be ahead by $2,550 (less transaction costs) as a result of these out and in trades to harvest losses, which may be invested in additional stocks or stock funds.
State and even local income tax savings might increase the dollar savings resulting from the loss harvesting strategy.
Rather than wait until December, a better strategy is to harvest your losses continually.
Why this makes sense: Cutting your losses at, say, 10% allows you to avoid large losses, which can be a good stop-loss discipline. In addition, there is no guarantee that you will have unrealized losses that you can take late in the year to achieve the desired $3,000 net capital loss for the year.
By harvesting losses more steadily, you can build up a bank of losses. Then you will be able to offset capital gains and take a $3,000 deduction on each tax return without any last-minute maneuvering.
How to do it: Track your taxable accounts carefully and sell whenever an issue is trading significantly below its purchase price.
General guideline: If you have a 10% unrealized loss, sell the stock or stock fund and invest the proceeds in another similar investment.
Flex plan: Harvesting losses gives investors a great deal of flexibility.
Example: Suppose that Williams harvests sufficient losses in 2008 to build up a “bank” of $35,000 in net capital losses. Meanwhile, a stock that he holds has shot up sharply in price and future gains are uncertain. Selling that stock would trigger a $30,000 taxable gain.
Without loss harvesting, Williams might be reluctant to sell the stock and realize a taxable gain. (This would be particularly true if the gain were short term.) With the banked losses, in this example, he can sell the stock without incurring tax obligations and reinvest the full amount in an issue he finds more promising now. The losses previously taken will offset the taxable gain.
Diversification: Some investors have highly concentrated portfolios — a great deal of their net worth is tied up in one stock, which makes them vulnerable to a drop in that issue.
If you are in this situation, a sale and reinvestment is a prudent move. You sell some of the shares of stock that make up most of your net worth, then reinvest the sales proceeds in something else to diversify your holdings. However, a sale might trigger sizable capital gains.
Taking losses on other positions may allow you to sell some of those appreciated assets and reinvest elsewhere to diversify and reduce overall risk without owing tax on the realized gains.
Beyond the stock market: Many individuals hold investments other than stocks.
Example: In a given year, you might have taxable gains from hedge fund shares, commodities, collectibles, investment property, the sale of a closely held company, sale of a vacation home, etc.
Net losses that have been harvested from a stock market portfolio can offset all of these types of gains. Thus, taking such losses can reduce your overall tax bill in many situations for years to come.
REINVEST AND REAP
To harvest higher long-term returns, when you sell to take a loss, reinvest the sales proceeds immediately in a new investment.
Benefit: With this discipline, you will be fully invested and, if you’re a skillful stock picker, you’ll be continually investing in timely prospects.
You probably will hold several different stocks or funds. Some may go up while others will go down. By constantly harvesting losses and reinvesting in more promising picks, you will reduce the tendency of selling winners too soon and holding on to losers for too long — a behavioral bias that has been documented to hurt investment performance for individual investors.
A disciplined tax loss harvesting program will delay taxable capital gains for a very long time. The improvement in after-tax return, compounded over decades, can mean a later portfolio value that is many times the value of a portfolio with no tax loss harvesting strategy.
DEALING WITH THE DOWNSIDE
Drawbacks to tax-loss harvesting…
Strategies: If you prefer to invest in mutual funds, stick with no-load funds, which have no sales charges, and funds without redemption charges.
For stocks, use a discount broker. Fees may be negligible, especially if you do your trading on-line.
If you prefer to work with a full-service broker or an investment adviser, request a fee-based account. The amount you pay will be based on the size of your portfolio — generally, from 1% to 2% a year — often without extra charges for trades. Portfolio minimums for such fee-based accounts, which most brokers offer, have come down to as low as $25,000.
After realizing a loss, be sure to reinvest in a different stock or fund.